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On August 1, Mattel recalled approximately 1.5 million toys made by a manufacturer in China because of dangerous levels of lead in their paint. The recall marks a continuation of the quality control problems that importers of Chinese-made exports have been experiencing over the past two months in products ranging from pet food to fish to tires. Four days earlier, the Chinese government ordered the country’s banks to increase their reserves and thereby reduce the amount of money they can lend to business — part of an effort to cool down an economy that is growing at its fastest rate in 12 years.

But quality concerns and rapid growth aren’t China’s only worries. There is also the government’s need to keep forging ahead on preparations for the Olympics next August in Beijing, despite some criticism about overdevelopment, human rights abuses and unsafe levels of pollution.

We recently interviewed Wharton finance professor Jeremy Siegel about his views on China’s growth. In this podcast, we asked Wharton management professor Marshall Meyer, who visits China about five times a year, for his perspective on how the Chinese government is handling its economy, and some of these other issues as well.

Transcript

Knowledge@Wharton: Let’s start out with Mattel’s recall, which affects toys made for the company’s Fisher Price unit. How serious a blow is this to the reputation of China’s manufacturing sector, which already has a big image problem because of earlier recalls?

Meyer: Well, it’s certainly a blow. I think that it just adds to the concerns that people have about the ability of Western companies or Chinese companies manufacturing in China to control the quality of the product.

Knowledge@Wharton: Is this something that the government is going to crack down on? Or is the Chinese government claiming that the U.S. has the same problems and that in fact other countries have similar manufacturing problems? They’re on the offense.

Meyer: Yes, the propaganda barrage from the central Chinese government has been, in my judgment, surprisingly muted. I think that they recognize they’ve got a problem. But I also think that there’s a false premise in your question, if you’ll forgive me, when you refer to “the government.”

There are many governments in China, and the ability of the central government to control commerce in China is very limited. There’s no counterpart to the U.S. commerce clause in the Chinese constitution. And so, whatever regulations or laws the central government makes, they are sometimes changed and often ignored by local governments.

Knowledge@Wharton: So, what would be a good strategy for U.S. companies, or other international companies that are sourcing production from China, to deal with this issue?

Meyer: There are a couple of things. First of all, they must simply pay a lot more attention, at some cost, to the quality of the product that they are getting from China. There’s no substitute for being there on the ground and knowing exactly who your sources are, and who their sources are. This is a particular problem in China because of the contracting. The subcontracting system often makes it less than transparent about who’s actually making a product.

Let me give you an illustration of the system, if I can. Suppose that I am in Shanghai, and I want to take a taxi out to Suzhou, which is about 45-50 minutes away. You find a cab driver and hypothetically you negotiate a fare with the cab driver for say 300 RMB or 350 RMB. And you hop in the cab and you think that you’re on your merry way to Suzhou. And he’s going in the right direction, but all of a sudden before he gets to the freeway, he stops, he sees his buddy and he waves him over — and basically he turns you over to his buddy. Maybe he gives the buddy 300 RMB and pockets the other 50 RMB right away. This kind of thing happens throughout China.

So that when Mattel says, for example, “We’ve been dealing with this source for 15 years, and we felt that we could really trust them,” they still might not know who the source is taking raw materials from, and in turn, from whom their source is getting the raw materials.

Knowledge@Wharton: How extensive a problem do you think this is?

Knowledge@Wharton High School

Meyer: I think given the price pressures that this is going to be extremely extensive because everything in China is driven by price. There are lots of small producers…. You go to [one location] where 80% of the toys come from, and you’re going to see hundreds and hundreds of these little shops producing components for these toys. Who knows where any particular piece is coming from? And so this is going to be difficult to handle unless and until both the Chinese and American firms go back to actually owning their sources of supply. Then they’ll have a little more control over them.

Knowledge@Wharton: Some people have suggested third-party testing as a way to get around this. But I suppose that has its own problems, including expense.

Meyer: You know, it’s as people say in the quality literature — you don’t want to fix the problem afterwards; you want to prevent the problems in the first place. That is why control is so important — and that may mean taking a greater ownership stake in firms that are now subcontractors.

Knowledge@Wharton: Could we talk now about China’s economy, which grew 11.9% in the last quarter and is growing at its fastest rate in 12 years? What’s your take on the growth rate, and what are some of the pluses and minuses?

Meyer: There are a couple of things. First of all, these numbers are coming fromthe National Bureau of Statistics. The statistical system in China is not perfect; some of my colleagues here at Wharton understand this much better than I do. The economic statistics are collected bottom-up from the provinces to the central government.

Again, it’s highly decentralized in China. The provinces and the provincial governors have strong incentives to maximize their GDP. They’re rewarded or punished for provincial GDP. Advancement within the political system depends upon provincial GDP. So the provinces tend to fulfill — as they said in the old Soviet Union — they tend to fulfill and over-fulfill their quotas. Often the NBS is in the position of tapping down on the statistics they get from the provinces. If you look at the provincial totals and you look at the NBS numbers, there is a disparity. There are issues with the numbers themselves.

Now there’s another issue. The central government, as you mentioned, has been taking some measures, both administrative as well as fiscal, to try to slow down GDP growth. But they can’t really control the banks. The banks are themselves fairly decentralized. Every province has a branch of Big Four commercial banks. The provincial branch is run [fairly] autonomously. This has changed a bit, but not a lot, since the banks have become joint stock companies and Western investors have taken positions in them. And so, just like the central government has trouble controlling local governments, bank headquarters have trouble controlling the branches of the banks.

Now, there’s an additional issue here. It’s what I call the perpetual motion machine in China. China builds goods for export and FDI [Foreign Direct Investment] comes into China as well. When the dollars or Western currencies come into China, they are all captured by the central bank, the People’s Bank of China.

The People’s Bank of China puts the dollars into China’s foreign reserves, which have been going up exponentially. They issue RMB in return for the dollars — but these RMB cannot leave China. The RMB is not convertible. The Chinese learned quite a lesson in 1997 when they saw Thailand and Indonesia get into real trouble because of convertibility of the currency. And the rest of the world was really angry at Malaysia when they shut the currency window, and yet they saved themselves a lot of pain by doing so.

So, you’ve got all of this RMB in China with no place to go except China and where does it end up? It ends up in further fixed asset investment — roads, factories and the like. Fixed asset investment leads to more production and more export and hence the perpetual motion machine. Unless and until there’s a little more convertibility of the currency, China’s GDP, China’s exports and China’s fixed asset investment are going to all go up together.

Knowledge@Wharton: That’s a really interesting point that you have raised because, in theory at least, the yuan should be appreciating as the foreign exchange reserves go up. That is exactly what is happening in India right now, where, because of the inflow of foreign capital into India, the rupee has been becoming stronger against the dollar. What prospects do you see, absent the convertibility of the yuan, of the currency regime changing to reflect global capital trends?

Meyer: I’m not really an expert on that. My guess on this would be — and I’m now going back to the 1985 Plaza Accords — where you’ll remember the U.S. forced up the Japanese yen. And what happened? The yen goes up, a lot of money flows into Japan, a lot of investment in Japan. And then, of course, came the bust in the 1990s in Japan. The currency went in and then it flew out of Japan — and Japan was in a decade-long recession.

Knowledge@Wharton: But do you think the yuan should go up in China?

Meyer: I don’t think that the valuation of the RMB is a critical factor here, because if you look at the Chinese contribution, the value added to things marked Made in China, it’s relatively small. Now I always like the iPod’s — if you look on the back of your iPod, it says Designed in California, Assembled in China. Where is the value added? Okay? If the RMB were to appreciate, let’s say 10%, just giving off a number — that would probably raise the cost of Chinese goods marked Manufactured in China by 1.5% to 2%; this is not earth shaking, but it is enough to affect folks in China.

You see, here’s the real issue of appreciation of the RMB. Investment in China — and I don’t know the Indian comparison — is inefficient. Returns on Chinese investments, except for the speculative stock market, are quite a bit below global returns on capital. So if the RMB goes up, you’ll get this kind of elastic effect, despite the currency controls. The currency will leak out because the returns are so much better outside China. As the currency leaks out and if the trickle becomes a torrent, what happens? Just like in Japan, the currency goes up, the currency goes down. I can make a case actually. I don’t think I would want to make it, but I could hypothetically make a case that the RMB is overvalued and not undervalued today.

Knowledge@Wharton: If you looked at the Chinese economy a year from now, what would you expect to see?

Meyer: I don’t know, because there’s a lot of uncertainty in the Chinese economy. One source of uncertainty is just in the stock market. The stock market has plateaued at around 4,000 for the Shanghai index and it strikes me at least as overvalued in relation to earnings. So that can have an affect on China.

I think that there’s a major source of strain in the economy. Let me give you a couple of numbers to illustrate this. In the United States, I’ve looked at the Department of Commerce figures; in the U.S. 46% of GDP consists of wages and salaries. The numbers in China in 1992 were 15%, and today they are 11%. And this is according to NBS[National Bureau of Statistics] numbers, so take or leave it.

There are a lot of folks in China who are farmers — more than half of the population that don’t have salaries and wages. There is a lot of non-salary, non-wage compensation. Some of it is corruption. So, it’s hard to compare the U.S. and China; it’s apples and oranges. But what is worrisome is the trend, not so much as the absolute levels.

And the central government’s policy is to get more money into the households and to increase the proportion of GDP that’s actually expended by the households. But it looks like they’re not succeeding. It’s going to take some Herculean efforts, I think, to move expenses out of fixed asset investment, out of things that contribute to the export economy — and in the direction of promoting domestic economic growth. I think that’s necessary, but it’s proving very, very hard to do because still there are powerful incentives in the opposite direction.

Knowledge@Wharton: Finally, what about the Olympics? Can China pull them off? What are some of the challenges there?

Meyer: Oh,China is great at execution — they will pull this off. You can count on it. Now, between today and a year from now, I would say that all bets are off. I mean, Beijing is utterly congested. They are building about 12 subway lines simultaneously. The amount of the other construction that is going on is unbelievable. Many of the construction sites don’t have nets, don’t have tents over them, so the dust, the particulate stuff in the air is probably at an all-time high. I’m not sure, but when you look out a window it seems as if there’s just a lot of particulate pollution. So, I say to people sometimes, “Go to Beijing but be careful what you breathe.”

But they will make it — there’s no question. This is so important to China’s self-esteem. Remember that China made an Olympic bid for 2000 and did not succeed in getting it and their pride was hurt. And they’ve put everything behind this effort to make it work and it will work, no doubt. But again, the amount of construction that’s going on in Beijing in the meantime is just a little bit disruptive of daily life.

Knowledge@Wharton: It seems like there are two contradictory forces here. They’re trying to develop enough of the infrastructure to handle all of the crowds, etc. In the meantime, they are creating so much pollution for the athletes. Isn’t there some concern that the city might be dangerous to people who are athletes?

Meyer: I’ll tell you a little story. In November of last year they had the China-Africa summit. I happened to be there at the time because it was the time of the Wharton 125th Anniversary tour in Beijing. And the air was remarkably clear. At the end of January, the last minute, my phone rings and a senior official in the central government said, “Come over and see me.”

I did, and we talked about this and that for half an hour. But I did ask him — I said, “The air was terrific during the China-Africa summit. What did you do”? And he said, “Oh it was simple — we seized the car keys.” And I said, “What car keys”? And he said, “The keys to all government cars.” And I said, “There can’t be that many cars.” He laughed and he said, “That was a half million cars that we took off the road.”

As I said, they are good at execution. They will shut down the worst polluters and they will take many, many cars off the road. And I would bet… if I could make this bet in Las Vegas, I would. I would bet that there will be blue skies for the Olympics in Beijing.

Knowledge@Wharton: What will they do with the thousands of construction workers that they’ve brought in from the countrysides?

Meyer: What they do with all national holidays; remember China has three national holidays that are one week long, and everyone goes home. And they will go home. The shanties in which they live will be dismantled. Again, they have a large work force, and they are good at execution.

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